CASE Network Studies and Analyses 350 - Ukraine at a Crossroads

S t u d i a i A n a l i z y
S t u d i e s & A n a l y s e s
C e n t r u m A n a l i z
S p o l e c z n o – E k o n o m i c z n y c h
C e n t e r f o r S o c i a l
a n d E c o n o m i c R e s e a r c h
350
Marek Dabrowski
Ukraine at a Crossroads
W a r s a w , S e p t e m b e r 2 0 0 7

Studies and Analyses 350-Marek Dabrowski – Ukraine at a Crossroads
Materials published here have a working paper character. They can be subject to further
publication. The views and opinions expressed here reflect the author(s) point of view and
not necessarily those of CASE.
Publication was financed by Rabobank Polska S.A.
Keywords: Ukraine, Orange Revolution, CIS, transition, European Naighborhood Policy,
Euro-Atlantic integration
2
Jel code: P21, P24, P26, P27, P33, P35
© CASE – Center for Social and Economic Research, Warsaw 2007
Graphic Design: Agnieszka Natalia Bury
ISSN 1506-1701, ISBN 978-83-7178-442-2 EAN9788371784422
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3
Contents
Abstract................................................................................................................................ 5
Introduction ......................................................................................................................... 6
1. The history of the Ukrainian transition: a comparative perspective............................ 8
1.1. The ‘lost decade’ of the 1990s ................................................................................. 8
1.2. Rapid post-recovery catch up in the early 2000s ..................................................10
1.3. Economic Developments after the Orange Revolution.........................................12
2. Medium and Long-Term Macroeconomic Challenges .................................................15
2.1. Looking for a more consistent monetary regime ..................................................15
2.2. Fiscal policy dilemmas............................................................................................18
2.3. Social policy reform ................................................................................................22
3. How can the business climate be improved?...............................................................24
4. Reforming a post-Soviet state.......................................................................................28
5. The challenge of globalization and economic integration...........................................32
Conclusions........................................................................................................................36
References..........................................................................................................................37

Marek Dąbrowski, Professor of Economics, Chairman of the Supervisory Council of CASE
– Center for Social and Economic Research in Warsaw, Chairman of the Supervisory Board
of CASE-Ukraine in Kiev, Member of the Board of Trustees of the Institute for the Economy
in Transition in Moscow, Member of the Executive Committee of the Association of the
Comparative Economic Studies (ACES), Member of the Scientific Committee of the
European Journal of Comparative Economics, and Member of the Consulting Board of the
‘Economic Systems’ journal. Former First Deputy Minister of Finance (1989-1990), Member
of Parliament (1991-1993) and Member of the Monetary Policy Council of the National Bank
of Poland (1998-2004). In the last twenty years he has been involved in policy advising and
policy research in Belarus, Bulgaria, Egypt, Georgia, Iraq, Kazakhstan, Kyrgyzstan,
Macedonia, Moldova, Mongolia, Poland, Romania, Russia, Serbia, Syria, Turkmenistan,
Ukraine, Uzbekistan and Yemen and in a number of international research projects related to
monetary and fiscal policies, currency crises, international financial architecture, EU and
EMU enlargement, perspectives of European integration, European Neighborhood Policy
and the political economy of transition. He has also served as a consultant to the World Bank
and UNDP.
4

5
Abstract
The Orange Revolution in the fall of 2004 built great hopes for a better future for
Ukraine. However, three years later those hopes have been replaced by disappointment,
frustration and confusion. Although progress in the areas of political freedom, pluralism, civil
rights and freedom in the media remains unquestionable the record of economic, institutional
and legal reforms is much more problematic. The key macroeconomic indicators are not
better than they were few years ago and the business climate has barely improved. The
WTO accession process remains incomplete. The perspectives of Euro-Atlantic integration
are continually subject to heated domestic political controversies. The political situation
remains unstable, mostly due to the hasty constitutional changes that were adopted during
the Orange Revolution.
The purpose of this paper is to analyze the state of the Ukrainian economy at the end
of 2007 and reflect upon what kind of reform program the Ukrainian government should
consider, regardless of its political color. The reforms suggested in this paper involve a broad
agenda of macroeconomic, social, structural and institutional measures. This agenda goes
beyond the purely economic sphere and also addresses issues of legal, administrative and
political reforms. The politics and political economy of any future reform effort will not be easy
because the country is deeply divided in political, cultural, regional and ethnic terms. In such
an environment, crucial reforms and strategic decisions will require a wider cross-party
political consensus.

6
Introduction
The Orange Revolution in the fall of 2004 built great hopes for a better future for
Ukraine, both within its borders and in its relations with other countries. The analogy with the
series of peaceful revolutions that took place in Central Europe in 1989, often referred to as
the “Autumn of Nations,” seemed obvious for many observers. Expectations that Ukraine
would follow the path of its more successful post-communist neighbors were high.
Three years after this great event, those hopes have been replaced by
disappointment, frustration and confusion. Although progress in the areas of political
freedom, pluralism, civil rights and freedom in the media remains unquestionable (although
not irreversible – see below) the record of economic, institutional and legal reforms is much
more problematic. The key macroeconomic indicators are not better than they were few
years ago and the business climate has barely improved. The WTO accession process
remains incomplete. Although the perspectives of Euro-Atlantic integration seem slightly
better than before, they are continually subject to heated domestic political controversies.
1
The political situation remains unstable, mostly due to the hasty constitutional changes that
were adopted during the Orange Revolution. The lengthy political stalemate which began
after the March 2006 parliamentary elections was finally resolved through the formation of a
majority government at the beginning of August 2006. Yet this did not put an end to the
ongoing constitutional conflict between the strengthened Prime Minister and weakened
President. On the contrary, the next round of this conflict erupted in the spring of 2007 and
led to early parliamentary elections at the end of September 2007. At the time of writing this
paper (early September 2007), the question of whether the new parliament will be able to
form a stable and reform-committed majority remains unanswered. Furthermore,
independent observers are expressing doubts over whether the September 2007 election will
be as clean and fair as the March 2006 election appeared (NDI, 2007).
In this paper, I argue that the current problems should not be surprising given the
previous poor reform record and the persistent difficulties in building a broad political
consensus in favor of a systematic pro-market and pro-democratic transition. The Orange
Revolution was not the first political window of opportunity which was lost for reforms. The
same happened immediately after Ukraine gained independence in 1991-1993, and after the
presidential elections in 1994. Even the most reform-oriented cabinet so far, appointed in
1
This relates, in particular, to future NATO membership, which has been questioned by the parties forming a
parliamentary majority in the parliament elected in March 2006.

1999 and led by Prime Minister Victor Yushchenko, had a very short political life (only 16
months) and limited political ability to implement crucial reforms.
Why does Ukraine face such major problems in building a stable pro-reform coalition
and implementing market-oriented economic reforms in a systematic way (in comparison to
other post-communist countries)? The answer to this question would require a complex
historical, political and sociological analysis and would need to consider factors such as
ethnic, language and regional differences. Unfortunately, taking into account my economic
background and experience, this is not a task which I am willing to attempt.
Rather, the purpose of this paper is to analyze the state of the Ukrainian economy at
the end of 2007, sixteen years after gaining independence and three years after the victory
7
on the Maidan,
2
and reflect upon what kind of reform program the Ukrainian government
should consider, regardless of its political color.
The paper is structured as follows: Section 2 offers a historical overview of Ukraine’s
transition after independence, including the period following the Orange Revolution. Section
3 deals with the macroeconomic problems of Ukraine’s economy, including the limited results
of the anti-inflationary effort and the inconsistency of the actual monetary/exchange rate
regime, fiscal imbalances and high level of fiscal redistribution of GDP, excessive social
welfare commitments which remain the root cause of the actual and future fiscal tensions. In
Section 4, I analyze the sources of the poor business climate in Ukraine and evaluate policy
measures which could help overcome this major obstacle to future rapid growth. To a large
extent, the effectiveness of these policies will depend on the reforms of state institutions,
including the legislative, executive and judiciary branches of government, as well as
administrative reform in local and regional self-governments (Section 5). In Section 6, I will
turn to perspectives for Euro-Atlantic integration. The discussion will include the geopolitical
aspect, the aspect most frequently and heatedly discussed, but will also touch on other
elements which can help to anchor the domestic reform process (particularly in the
institutional sphere), which will determine Ukraine’s position in the international division of
labor for many decades to come. Section 7 will present final conclusions and policy
recommendations.
In the paper, I will draw mostly from my own experiences in the area of policy
research and policy advising in numerous post-communist countries over the last 20 years,
including my extensive engagement in Ukraine’s reforms since 1993. However, even the
2
Maidan Nezalezhnosti (the Independence Square) in Kiev where the main events of Orange Revolution took
place became the symbol of this revolution and its victory.

best personal insight is not sufficient to give a complete picture of a country’s problems and,
most importantly, a comprehensive set of policy recommendations. Drawing on the analyses,
observations and proposals of other experts is an obvious necessity and thus I have drawn
on the research of economists from CASE and CASE Ukraine. In the historically crucial
period of 2004-2006, I participated in joint-research projects with distinguished scholars and
experts involved in the UNDP Blue Ribbon Commission project (which resulted in two
comprehensive reports – see UNDP 2005a, 2005b) and the UNDP-sponsored Blue Ribbon
Commission II International Advisory Group, coordinated by CASE and CASE Ukraine.
8
3
This
4
.
study partly draws on several detailed studies and analyzes conducted under this project
When relevant, I will make more detailed references to particular sources of
information, opinions and recommendations. However, I assume sole responsibility for this
paper’s content and quality. The presented opinions and recommendations are entirely my
own and do not necessarily reflect the position of my colleagues, CASE, CASE Ukraine,
UNDP and the other institutions with which I have cooperated.
1. The history of the Ukrainian transition: a comparative
perspective
1.1. The ‘lost decade’ of the 1990s
Of all the former communist countries, Ukraine’s transition to a market economy has
been one of the most difficult and painful. Adaptatitive output decline, an unavoidable
phenomenon after the collapse of a command economy, lasted for 10 years in the case of
Ukraine (the longest period out of all the transition economies) and amounted to 61.5% (the
second largest, after Moldova, among countries not involved in military conflicts – see
Dabrowski, 2004b, Table 1). The enormous scale of this so-called ‘transformation recession’
is largely due to the unfavorable starting conditions, i.e. the costs of overcoming Soviet
structural distortions and institutional legacy. The exceptional length of output decline was
caused by a slow and unsystematic pace of reforms in the 1990s.
The first years of Ukrainian independence under the presidency of Leonid Kravchuk
(1991-1994) were almost totally lost in terms of market transition. This was in sharp contrast
with the rapid economic reforms in the Baltic countries at the same time, which had quite
similar starting conditions to those of Ukraine. A lot of political energy was spent on the
superficial transformation of the former Soviet institutions into the Ukrainian (national) ones,
3
See http://www.case.com.pl/strona--ID-ukraina,projekt_id-8820735,nlang-710.html;
4
I would like also to thank Paulina Szyrmer for her excellent editorial assistance in preparing this paper.

instead of building and importing the institutions of liberal capitalism from the West, as was
done in Central Europe and the Baltic region.
Economic policy was dominated by populism: irresponsible social entitlements, price
controls, subsidies and other spending commitments, huge fiscal deficits, multiple exchange
rates, netting-out operations (vzaimozachet), crediting loss-making state owned enterprises,
and money printing.
As a result, Ukraine suffered hyperinflation at the end of 1993 (see Dabrowski, 1994).
By December 1993, twelve months of inflation amounted to 10.155%. It was the fourth
highest in the post-communist world (see Dabrowski, 2003: 9). The cumulative inflation
during the first five years of transition (December 1991 – December 1996) was one of the
highest even among CIS countries (Koen & De Masi, 1997). Privatization became effectively
frozen and trade liberalization was only partly implemented. In terms of the overall transition
progress, Ukraine lagged behind not only Central Europe and the Baltic countries, but also
behind Russia and smaller CIS countries such as Kyrgyzstan, Armenia, Moldova and
Georgia.
The fall of 1994 and 1995 (after 1994 Presidential elections ended with the victory of
Leonid Kuchma), brought the first more comprehensive attempt to speed up the transition
process. This included price liberalization and exchange rate unification, limited trade
liberalization, and credit tightening. The authorities also curbed fiscal deficit, introduced a
new currency (hryvna), and launched a large scale voucher privatization program. However,
the pace of implementation was rather slow and uneven, due to frequent changes in the
composition of the government and extensive political bargaining.
When the perspective of economic recovery seemed to be around the corner, Ukraine
suffered a serious currency and debt crisis in the second half of 1998 and beginning of 1999,
following similar developments in Russia and many other CIS countries. This delayed
economic take off by at least one year.
The 1998-1999 crisis proved that the earlier fiscal adjustment was insufficient, and
the recently achieved exchange rate and price stability - unsustainable. In fact, the
macroeconomic fragility of the second half of the 1990s was deeply rooted in the
microeconomic, structural and institutional spheres. Economic recovery was delayed due to
slow privatization, soft budget constraints, lack of payment discipline (particularly in an
energy sector), tax, budget, wage and pension arrears, widespread barter and netting out
operations, using money surrogates, and persistent trade barriers. These phenomena also
had a negative impact on fiscal and monetary equilibria. (see Dabrowski et al., 1999).
9

1.2. Rapid post-recovery catch up in the early 2000s
Finally, the post-adaptation growth recovery came at the end of 1999, almost 8 years
later than in Poland, 7 years later than Slovenia, 6 years later than the Czech Republic,
Slovakia, Hungary and Armenia, 5 years later than Estonia, Lithuania, and Georgia, 4 years
later than Latvia, Azerbaijan, and Kyrgyzstan, and with a only a half year lag, when
compared with Russia (Dabrowski, 2004b). A unique feature of the Ukrainian recovery was
its exceptionally high rate of growth in 2000-2004 (one of the highest in the region). Parallel
to the high rate of economic growth, some other key macroeconomic indicators (current
account balance, international reserves of the NBU, exchange rate, inflation, fiscal deficit,
public debt to GDP ratio) represented either a good or at least an acceptable record (see
10
Table 1)
5
.
Table 1: Ukraine: Basic Macroeconomic Indicators, 1999-2007
Indicator 1999 2000 2001 2002 2003 2004 2005 2006 2007f
real GDP growth in % -0.2 5.9 9.2 5.2 9.6 12.1 2.6 7.1 6.8
annual inflation in % 19.2 25.8 6.1 -0.6 8.2 12.3 10.3 11.6 11.3
UAH/USD exchange rate, eop 5.22 5.4 5.3 5.33 5.33 5.31 5.05 5.05 5.05
current account balance in % of GDP 5.3 4.7 3.6 7.7 5.8 10.6 3.1 -1.5 -3.8
fiscal balance in % of GDP -1.5 -0.6 -0.3 +0.7 -0.2 -2.9 -1.7 -0.7 -1.9
Source: Ukrainian Economic Outlook (UEO), subsequent issues, http://www.case-ukraine.
com.ua/index.php?mode=static_page&pid=10
Figure 1. Composite metal price index, 1980-2006
Source: WEO (2006 April), Figure 1.24, p.62
The high growth rate and positive macroeconomic developments of the early 2000s
may be attributed to several factors (see Dabrowski, Jakubiak et al., 2003). Part of them had
5
In preparing the macroeconomic part of my analysis I drew extensively from statistical data, information and
opinions provided in the “Ukrainian Economic Outlook,” a quarterly publication produced by a team of experts
from CASE Ukraine (see http://www.case-ukraine.com.ua/index.php?mode=static_page&pid=10), led by Dmytro
Boyarchuk. However, the earlier disclaimer on my sole responsibility for the content and quality of this paper also
applies to this particular component.

a temporary (windfall) character and were generated by factors such as import substitution
and real depreciation of a significant part of the budget expenditure commitments as a result
of the 1998-1999 hryvna devaluation. Other windfall factors such as high international prices
of metallurgy products (see Figure 1), and indirectly - through Russia’s import demand - high
international oil prices, persisted over the entire period analyzed.
Beyond the windfall factors, the Ukrainian economy began to benefit, at last, from the
reform efforts undertaken in the second half of 1990s, particularly from the privatization of the
manufacturing industry, trade and service sectors, and agriculture (though the latter was
privatized with a significant delay and has numerous remaining barriers). On the top of this,
the second wave of reforms undertaken mostly in 2000-2001 by the cabinet of Victor
Yushchenko helped to address some of the afore-mentioned structural and institutional flaws
of the Ukrainian economy. This relates, in the first instance, to an improved budget, tax and
payment discipline, including energy payments and other infrastructure services. Secondly,
the simplified tax regime and some progress in the area of deregulation helped in the
development of small and medium size enterprises (SME) and pushed many small
businesses to legalize their previously unregistered economic activity in 2000-2001.
The early years of 2000s also brought an intensification of cash privatization in the
metallurgy, chemical and petrochemical industries and partly in the energy distribution
sector. However, this process lacked sufficient openness and transparency and was
subordinated to the interests of those oligarchs who were closely associated with the
President and Government. Corruption and nepotism had to provoke an anti-privatization
backlash during and after the Orange Revolution (see below). The metallurgical giant
Krivorozhstal became the most spectacular example of non-transparent and unfair
privatization of the late Kuchma presidency. It was sold in 2004 to the consortium formed by
the System Capital Management and Interpipe (two biggest oligarchic conglomerates very
close to President Leonid Kuchma and Prime Minister Viktor Yanukovich) for USD 800
million (see Paskhaver & Verkhovodova, 2006). Renationalized a year later it was sold again
in October 2005 in the open and transparent international tender to the Mitall Steel Germany
Gmbh for USD 4.8 billion (six times more).
Finally, in 2004, Ukraine launched a Russian-type reform of the personal income tax
(with single tax rate of 13%), which created the opportunity to make the tax system more
business-friendly and limit incentives to move to a shadow economy. However the remaining
elements of the tax system and the entire system of tax administration remained hostile to
business activity and continued to be perceived as one of the major sources of corruption
and poor investment climate (Golodniuk et al., 2005).
11

In 2004, the year of the presidential elections, the rate of GDP growth (12.1%)
reached its highest historical level in independent Ukraine, due to very favorable external
factors and at the cost of deteriorating domestic macroeconomic equilibria. The high
international demand and high prices for metallurgical products were additionally supported
by an exchange rate policy conducted by the NBU: pegging the hryvna to the USD meant its
nominal depreciation to other currencies at that time.
Loose monetary and fiscal policies boosted private consumption and the latter
became the main engine of economic growth in 2004 and 2005. Most of the rapidly
increasing budget spending was directed to increase public sector wages and salaries and
social transfers, which had unavoidable inflationary consequences. After reaching its lowest
(i.e. negative) level in the summer of 2002 (mostly due to exceptionally good harvest in 2001
and rapid decrease in food prices), the annual CPI inflation systematically increased, already
reaching two-digit levels in Q3 2004. Inflation began to decelerate only in the fourth quarter
of 2005
1.3. Economic Developments after the Orange Revolution
Economic developments during and after the Orange Revolution were characterized
by contradicting trends and decisions, such as: (1) the increased fragility of property rights on
top of a political campaign demanding the review and revision of major privatization deals
conducted under the Kuchma presidency; (2) the halt of the privatization process; (3) the
elimination of many tax distortions; (4) social populism; (5) some progress in WTO accession
and EU integration; (6) and increased inflow of FDI.
As mentioned in the previous subsection, unfair and intransparent privatization
practices under Kuchma’s presidency triggered the revolutionary demand to review the past
deals and return “stolen” national property to the Ukrainian state. Renationalization calls
have been shared by virtually all the leaders of the Orange revolution
12
6
. However, many of
them withdrew their support for renationalization during the course of 2005, after realizing
how dangerous this idea was for the investment climate. The differences in views between
individual politicians related to the scale of revision of the past deals: from just a few of the
biggest and most spectacular transactions to hundreds or thousands (see Paskhaver &
Verkhovodova, 2006 for details of this debate).
6
In Ukraine the notion of “reprivatization” is used rather than “renationalization”. The former implies that
renationalized property will be privatized again soon (as really happened in the case of Krivorozhstal). However,
outside Ukraine, “reprivatization” usually has a different meaning – the restitution of private ownership in relation
to property nationalized by communist regimes in the past. To avoid confusion, I will use the term
“renationalization” as it better reflects the essence of the analyzed phenomenon – reversing the previous
privatization transaction by the state (regardless of the subsequent steps in respect to the seized property).

The first post-revolutionary Prime Minister Yulia Timoshenko became the main and
most aggressive advocate of large-scale renationalization in the first half of 2005. After her
dismissal in September 2005, the new Prime Minister Yuriy Yekhanurov undertook a mostly
successful effort to calm down emotions and uncertainty created by the renationalization
campaign. Even if the actual renationalization on the national level has been limited to the
13
three major cases so far,
7
the entire debate and controversy seriously deteriorated the
perception of property rights protection, which had already been poor prior to the campaign.
In addition, a tendency to question past ownership transactions spread throughout the
country, undermining property rights on the local level
8
.
The negative growth effects of the renationalization campaign and some of the other
populist moves made by the Timoshenko government (attempts to impose an administrative
price control of oil and meat products in spring 2005) could not surprise anybody. If one looks
for quarterly GDP data, the annual growth rate reached its highest level in Q3 2004 (14.2%),
then rapidly decelerated: to 9.1% in Q4 2004, 4.9% in Q1 2005, 3.4% in Q2 2005, 1.4% in
Q3 2005, 1.7% in Q4 2005. Recovery came in 2006: GDP started accelerate again quarter
by quarter – 4.1% in Q1 2006, 6.8% in Q2, 6.9% in Q3, 9.5% in Q4 and 8.0 in Q1 2007
(UEO, 2007 Q2, table 1, p.38). Investment stagnation and negative net export proved an
effective counterweighted to the highly dynamic private consumption of 2005.
Political instability and the controversy around past privatization deals also paralyzed
the new privatization projects. Apart from very high revenue obtained from the repeated
Krivorozhstal tender (see above) few other minor transactions brought a limited amount of
budget proceeds in 2005 and 2006 (see Paskhaver & Verkhovodova, 2006). The first major
privatization decision in respect to six regional energy distributing companies was taken by
the Cabinet of Ministers only in April 2007.
In the fiscal policy sphere Timoshenko’s government undertook several measures
aimed at disciplining the revenue side: they eliminated numerous tax loopholes (like free
9
, increased discipline and started
economic zones), tax exemptions and special tax regimes
to fight corruption in the tax and customs administration, decreased and simplified import
tariffs, etc. As result, the total revenue of the consolidated budget (not including the Pension
Fund) increased from 26.5% of GDP in 2004 to 32.0% in 2005 (UEO, 2006 Q1, Table 8.1, p.
7
I.e. Krivorozhstal, the Insurance Company “Oranta” and the Nikopol Ferroalloy Plant (unfinished case) - see
Paskhaver & Verkhovodova (2006).
8
The low level of professionalism, widespread corruption and systemic chaos in the judiciary further undermined
the stability of property rights.
9
Part of this progress was reversed in 2006 and 2007.

15). Increasing tax discipline and eliminating numerous tax distortions (meaning a more
equal treatment of various categories of taxpayers) should be considered a great policy
success. On the other hand, additional revenues have been immediately spent on wage and
pension increases and other social programs instead of decreasing general tax rates or
eliminating the most distortive taxes.
Table 2: Dynamics of social expenditures (2002-2005) in % of GDP
Item 2002 2003 2004 2005 2005-2002
GG expenditure 37.7 38.7 41.1 45.2 +7.5
Social protection 15.6 14.8 16.6 20.9 +5.3
14
Source: IMF (2007c), Table 18, p.22
The major expansion of social transfers (see Table 2) resulted from both the
populism of Yanukovich’s government in 2004 and the additional wage and social obligations
adopted by the new administration already after the Orange Revolution (for example,
transfers of ca. USD 1,500 for each new-born child). If not for higher-than-expected inflation
in 2005, which helped to limit the real fiscal consequences of the new social commitments in
the short-term, the real expenditure expansion would be even higher. In the longer term, the
already-granted social entitlements, especially those related to a pension system, are fiscally
unsustainable (see Section 3).
In early 2005, President Yushchenko launched a very aggressive diplomatic
campaign in order to bring Ukraine closer to the European Union and NATO. It resulted,
among other things, in signing the EU-Ukraine Action Plan in February of 2005 (under the
umbrella of the European Neighborhood Policy) and obtaining Market Economy Status in
the EU and US for anti-dumping purposes. However, implementation of the Action Plan is
moving with a mixed speed and effects (see Jakubiak, Kolesnichenko et al., 2006).
Accession to the World Trade Organization is an important condition and milestone on the
road to future trade liberalization between the EU and Ukraine. Although the negotiations are
advanced, the accession has not been completed yet, mostly due to legislation obstacles
faced by subsequent governments in the Verkhovna Rada
10
. The NATO accession process
was effectively frozen by Prime Minister Victor Yanukovich in the second half of 2006.
In spite of the limited progress in improving business climate, the rather slow pace of
Euro-Atlantic integration and a high level of political uncertainty, the post-revolutionary period
brought an increase in foreign direct investment (FDI), particularly in the financial sector. The
FDI annual inflow increased from USD 1.4 billion in 2003 and 1.7 billion in 2004 to USD 7.5
10
The full list of the proposed legislative changes is presented at UEO (2006 Q3), Table 2.8.1

billion in 2005 (including the Krivorozhstal transaction of USD 4.8 billion) and USD 5.3 billion
in 2006 and reached the cumulated stock of some USD 22 billion (about USD 470 per capita)
by the end of 2006 (UEO, 2006 Q1, p. 19; UEO, 2007 Q2, Table 9, p.46 and author’s own
estimation). This is still below the level achieved by the Central European, Baltic and Balkan
countries but may signal an improving international perception of Ukrainian economic
perspectives and the further acceleration of FDI inflow in future. A parallel increase in net
portfolio investment has been also recorded (Lozovoi & Kudina, 2007).
2. Medium and Long-Term Macroeconomic Challenges
A superficial analysis of key macroeconomic indicators (see Table 1) may suggest
that Ukraine will not face serious macroeconomic tensions in the near future. However, such
an opinion would be wrong. The period of post-adaptation output recovery associated with
the fast remonetization of the economy and the high pace of budget revenue increase seems
to be over. Fundamental inconsistencies in the actual monetary/exchange rate regime, which
systematically cumulated during the past seven years, will become even more harmful with
the increasing financial and investment openness of the Ukrainian economy. Modest fiscal
imbalances will also become more acute if economic growth decelerates at some point11 and
as result of unfavorable demographic trends. These challenges need an adequate and timely
response if Ukraine wants to avoid more serious macroeconomic tensions in the future.
2.1. Looking for a more consistent monetary regime
As mentioned earlier, Ukraine has had problems in bringing inflation to a sustainable
low one-digit level. This seems to be closely linked to the fundamental problems and
inconsistencies experienced by monetary policy. If one looks into money supply statistics,
one will find a very high growth rate of monetary aggregates through the entire post-1998-
1999-crisis period. A broad money aggregate M3 increased by 35.1% in 1999, 46.4% in
2000, 37.7% in 2001, 42.8% in 2002, 47.9% in 2003, 44.9% in 2004, 38.6% in 2005 and
39.2% in 2006. Monetary base grew by 41.4% in 1999, 39.1% in 2000, 35.3% in 2001,
42.0% in 2002, 29.0% in 2003, 36.5% in 2004, 37.8% in 2005 and 25.0% in 2006 (UEO 2005
Q4, Table 14, p.47; 2006 Q3, Table 14, p.45; 2007 Q2, Table 14, p.51). The faster rate of the
growth of M3 than the monetary base reflected increasing financial intermediation and,
therefore, of the money multiplier: from 1.91 in 2000 to 2.66 in 2006 (UEO 2007 Q2, Table
14, p.51). The rapidly growing official international reserves of the National Bank of Ukraine
15
11
Referring to an analytical framework frequently used in more developed market economies one can argue that
the “cyclically adjusted” fiscal deficit has been higher than the actual one. While the question of whether Ukraine’
economy has already experienced a regular business cycle is highly debatable, there is little doubt that high
growth rates in 2000-2004 and 2006-2007 helped to mask actual fiscal imbalances.

(NBU) (up to USD 27375.39 million at the end of July 200712) were the main factor
contributing to this extraordinary pace of monetary expansion, in spite of quite intensive
sterilization in 2004-2005 which was mostly aimed at reducing the NBU net claims to
government.
This brings us to an exchange rate policy which focused on defending the hryvna
against appreciation pressure through the entire post-crisis period13. The UAH/USD nominal
exchange rate was relatively stable through the entire 2000-2007 period, with one
discretional revaluation conducted in March and April 2005 (from 5.30 to 5.05 UAH for 1
USD), which partly offset the inflationary effects of substantial USD depreciation vis a vis the
EUR in 2003-2004.
As any exchange rate target in an economy with a high degree of de facto capital
mobility,14 the fixed but adjustable peg of the UAH to the USD makes money supply and
inflation mostly exogenous, i.e. outside the central bank’s control. On the other hand, the
UAH/USD peg helped in rapid remonetization: M3/GDP more than doubled – from 19.0% in
2000 to 49.8% in 2006 (UEO 2007 Q2, Table 14, p.51), which absorbed most of the rapidly
growing money supply. However, the dollarization of commercial banks assets and liabilities
remains high15. The same seems to be true for cash transactions although, for obvious
reasons, this observation is based on anecdotal evidence rather than on comprehensive
statistics. Political turbulences and subsequent election campaigns caused periodical
confidence mini-crises and flights from hryvna to dollar (the biggest one was observed in
November and early December 2004).
One can argue that a fixed exchange rate provides an automatic mechanism which
adjusts the money supply to money demand through a balance-of-payments channel and it
should sooner or later bring a far-reaching inflation convergence with an anchor currency
area16. This is true in the case of stable and credible pegs, mostly the so-called “hard pegs”,
i.e. currency boards or adopting either a common currency or other country’s currency.
16
12
http://www.bank.gov.ua/ENGL/SDDS/Dates/dates_e.htm
13
This pressure was additionally enhanced by the substantially undervalued exchange rate of the hryvna after the
1998-1999 financial crisis.
14
Formally, Ukraine continues various capital account restrictions but their effectiveness in controlling capital
movement is very problematic.
15
According to the IMF (2005b, Table 4, p. 76) while the share of foreign exchange deposits in total deposits
decreased from 39.0% at the end of 2000 to 32.1% in June 2005 the similar ration for foreign exchange
denominated credits increased from 33.8% to 38.0 for the same period.
16
Under a fixed exchange rate regime inflation differences can originate from: (i) initial under- or overvaluation of
fixed exchange rate, i.e. PPP differences in respect to tradables; (ii) Balassa- Samuelson effect; (iii) changes in
exchange rates between major currencies if a country’s foreign trade transactions are denominated in various
currencies.

Ukraine’s soft peg is far from this model because (i) the exchange rate can be formally
changed at any time; (ii) NBU continues operations on its domestic assets.
The current monetary/ exchange rate regime belongs to the broad category of
intermediate (hybrid) regimes, which seem to be incompatible with mostly unrestricted capital
mobility. Its first flaw is that hybrid regimes are unlikely to provide the same advantages as
pure ones, i.e. neither an exchange rate anchor nor sufficient discretion in managing
domestic liquidity. Second, compromised regimes are technically very difficult to manage
because of fluctuating demand for money and changing market expectations. Moreover,
political pressure may cause temptation to go beyond the compromise. Third, the
transparency, and, therefore, the credibility of intermediate regimes is lower than that of the
‘corner’ solutions. This last weakness has been evident in financial crises of the 1990s (see
Dabrowski, 2001 for general discussion; Jakubiak et al., 2005 in respect to Ukraine).
As a result, hybrid regimes may provoke a speculative attack against the hryvna at
the time of serious macroeconomic or political turbulences. The afore-mentioned episodes of
political instability and speculative pressure on the foreign exchange market (for example, at
the end of 2004) provide clear evidence that this is not a purely hypothetical threat.
Thus, Ukraine should depart from the current hybrid regime towards one of the
‘corner’ solutions as fast as it can by either choosing a sovereign monetary policy with a free
float or adopting a ‘hard’ peg (see Frankel, 1999; Mundell, 1999; Krugman, 1999;
Eichengreen, 1999). The IMF (2005a, pp. 21-22) supports the first option and recommends
moving to direct inflation targeting (DIT) and a flexible exchange rate. This regime has been
tried in recent decade in a number of transition and developing countries (including the
Czech Republic and Poland) and has brought satisfactory disinflation results.
However, adopting DIT requires a lot of preparatory steps (see IMF, 2005a, Box 2, p.
22) such as implementing legal and institutional changes (a higher degree of NBU
independence from both executive and legislative branches of government), developing and
deepening the money and foreign exchange market, liberalizing capital accounts, moving to
a free floating exchange rate, making radical changes in the monetary policy operational
framework and instruments, developing statistical, analytical and forecasting capacities of the
NBU and independent analytical centres. Some of these steps, like making the exchange
rate flexible, may prove politically difficult to carry out. All of them will take time:
approximately 2-3 years from the beginning of implementation to complete adoption (see
Dabrowski, 2006).
17

The opposite ‘corner’ solution, i.e. a ‘hard’ peg seems to be technically easier to
adopt as it would continue using the existing exchange rate anchor. However, its adoption
would require, however, abandoning any discretionary monetary policy operations (in fact,
giving up sovereign monetary policy and any active role for the NBU in this sphere) and fixing
the exchange rate forever. This should involve a serious discussion on the choice of an
anchor currency; while the US dollar is the dominant currency of global financial transactions
and investment decisions, as well as savings and trade with CIS and developing countries,
the importance of the Euro will increase after Ukraine’s deeper trade and economic
integration with the EU.
Both ‘corner’ solutions have their advantages and disadvantages (see Dabrowski,
2004) which must be balanced and analyzed carefully before making a definite regime
choice decision.
18
2.2. Fiscal policy dilemmas
Fiscal expansion constituted another important source of inflationary pressure. Until
2003, the Ukrainian budget was relatively balanced with the deficit not exceeding 1.5% of
GDP (see Table 1) although in conditions of such a high rate of economic growth it should
record a substantial surplus rather than deficit. Due to new expenditure commitments, the
fiscal situation deteriorated dramatically in the second half of 2004 during the election
campaign and Orange Revolution,. In Q4 2004, fiscal deficit accounted for 8.5% of GDP and
for all of 2004 it amounted to 2.9% of GDP. As mentioned in Section 2.3, expenditure
expansion continued in 2005 but was counterbalanced by the fact that revenues were
increasing even faster, which helped to bring some fiscal consolidation (fiscal deficit of 1.7%
GDP). Similar trends, i.e. rapidly increasing expenditures and even faster-growing revenues17
were observed in 2006.
As a result, Ukraine has already joined the group of high-spending countries of
Western and Central Europe, disregarding its much lower level of income per capita, when
compared to those countries. This will not help in sustaining a high rate of economic growth
as higher expenditures must mean higher taxes sooner or later (see below). This, in turn, will
decrease the rate of private saving and investment, push business activity to the “shadow”
zone, and decrease labor market participation (see Rohozynsky, 2007).
The level of public debt is not very high by international standards and is continuously
diminishing in relation to GDP from its peak level in 1999, i.e. immediately after the currency
17
Acceleration of economic growth also contributed to a rapid increase in revenue in 2006.

crisis and near-default (see Figure 2). The government can borrow relatively cheaply on both
domestic and international financial markets. However, this quite comfortable picture will not
necessarily last forever. First, the early 2000s were marked by extraordinary low interest
rates and financial calm on international markets. At least the first part of this characteristic
seems to be definitely over: interest rates are systematically going up. Second and more
important, apart from official public debt, Ukraine accumulated the substantial implicit debt of
the PAYG pension system (unfunded pension liabilities), which will further increase due to
unfavorable demographic trends in the next several decades. The recent expansion of social
spending additionally complicates this picture because once granted, social entitlements
cannot easily be withdrawn in bad fiscal times. Third, contingent liabilities in the financial
sector constitute another form of the implicit public debt. They originated mostly from the
political commitment to compensate Ukrainian citizens’ heavy loses in the real value of their
saving deposits due to hyperinflation in the first years of independence. Although the amount
of these liabilities is not precisely determined and is not indexed against the current inflation
it still remains at levels well exceeding the official public debt (see Figure 2 and IMF, 2007a,
Box 2, p. 17). Furthermore, as this issue continues to be the subject of heated political
debate, especially during the subsequent elections one cannot estimate the ultimate fiscal
consequences and timetable of its resolution.
Figure 2. Public debt and contingent liabilities, % of GDP, 1999-2006
19
Source: IMF (2007a), Figure 6, p.16
All the above described circumstances urgently call for a new round of substantial
fiscal adjustment, which should focus mostly on an expenditure side, especially on social
spending. Unfortunately, this has not been the case. The reduction and rationalization of
social spending have been consequently opposed by subsequent governments and
parliaments over the last fifteen years and these policy ideas have become taboo in

Ukraine’s reform debate. Instead, both politicians and professional economists have
discussed various scenarios of tax reduction, either totally disregarding their negative
revenue consequences, or taking excessively optimistic assumptions in respect to the size
and speed of a positive supply-side response (a naive hope in a strong Laffer curve-type
effect). A leading motive of many “radical” proposals, especially those elaborated and
discussed by the National Committee for Tax Reform (the ad-hoc advisory body appointed
by President of Ukraine in 2005) and advertised by Vodomyr Lanovoi, the Advisor to the
President of Ukraine (Margalyk, 2005) has been: Cut tax rates and get almost immediately
higher tax revenue because of “de-shadowing” of informal economy
It is worth remembering that the original Laffer curve idea (Laffer, 2004) represented
a rather supply-side concept: increased output and employment as a result of a lower tax
burden. However, in the specific context of transition economy, one can expect an additional
effect: the “de-shadowing” of the economy due to lower tax rates, which can bring additional
revenue gains (see Walewski, 2001). The “optimists” in a tax reduction debate clearly expect
that such a “de-shadowing” would immediately overcompensate loses caused by the
reduction of tax rates in the case of an economy with a large unregistered sector like
Ukraine. “Skeptics” or “realists” call for a realistic estimation of the positive effect in terms of
its expected size and time lag. First, in the case of particular tax one must know at which
concrete point of a Laffer curve the Ukrainian economy is at now. This may be not so easy to
assess with a wide margin of uncertainty in respect to possible fiscal consequences. Second,
taxpayers’ reaction will depend not only on the reduction of tax rates but also on many other
accompanying measures and factors such as quality of tax administration, expected stability
of the new rates and rules, deregulation of business activity, protection of property rights,
political stability and predictability, etc. Third, no positive reaction can be expected to happen
overnight.
Calls for deep unilateral tax cuts became particularly strong during subsequent
election campaigns and in the period of political radicalization following the Orange
Revolution. On the other hand, a sharp increase in the level of fiscal redistribution of GDP
during and after the Orange Revolution has dramatically narrowed the room for maneuver for
any tax reform. A country which redistributes more than 40% of its GDP through its budget
and off-budgetary funds, cannot have low and non-distorting taxation, unless the level of
public expenditures is substantially reduced.
The additional constraint comes from the structure of public expenditures. As almost
half of them are directed towards various forms of social programs and social transfers (see
Table 2) this limits the room for reduction of high payroll taxes, which are so direly needed
20

from the point of view of “de-shadowing” the informal sector and labor relations. The Pension
Fund already runs a deficit of around 5% of GDP and cutting the Pension Fund contribution
rate without a reduction of pension entitlements would mean a further increase in budget
transfers financed from other sources. Hypothetically, such a transfer could be financed from
VAT but (i) the VAT rate is already high (20%) and cannot be further increased; (ii) such a
maneuver would further weaken the link between pension contributions and future benefits
and the chance to build an insurance or quasi-insurance type of pension system.
Without an expenditure reduction, only minor changes in tax rates are possible. First,
a further elimination of remaining tax exemptions, of which there are not many (in terms of
their value) might allow for some decrease in basic tax rates (enterprise profit tax in the first
instance). Second, one can consider moving the tax burden between various taxes, i.e.
decreasing the rate of some existing taxes at the expense of increasing others or creating
new taxes. While some moves of this kind seem to be possible and justified, one must be
extremely careful in estimating their immediate fiscal effects. For example, the introduction of
a real estate tax, which would finance local budgets, could create some room for lowering
other taxes. However, this kind of reform requires a lot of time and effort before the new tax
will become operational.
Some proposals of the tax reform neglect the external institutional constraints such as
the consequences of the expected WTO accession or the country’s ambitions to advance its
economic integration with the EU. If Ukraine wants to become deeply integrated into a global
and European economy and improve its business climate for foreign investors it must make
its tax system compatible with the European ones. This means the ideas to replace VAT with
a turnover or sales tax advocated by some Ukrainian politicians and lobbyists during
subsequent election campaigns will go exactly in the opposite direction (besides the many
other serious flaws of this proposal).
Apart from a fiscal adjustment based on expenditure reduction, Ukraine needs a
further strengthening of fiscal management rules, which would help to avoid continuation of
fiscal imbalances and further build up of explicit and implicit public debt. On the other hand, it
would provide more transparency in fiscal accounts and an institutional framework for
increasing effectiveness and improving targeting of public expenditure. This set of measures
can include:
• legal limits on the size of the deficit (or the zero-deficit principle) and public debt (in
21
nominal terms or in relation to GDP);

• a legal obligation to estimate the fiscal consequences of new legislation by an
independent accounting (actuarial) office/ agency; this kind of provision is particularly
important in case of social and tax legislation;
• strengthening formal prerogatives of the Minister of Finance inside the government
and the Budget Committee inside the parliament;
• the exclusive right of government to propose legislation initiatives, which bring serious
fiscal consequences (or the right of government to veto such initiatives of MPs);
• mandatory medium-term fiscal planning (especially in respect to public investment
22
projects and social programs)
• full harmonization of the fiscal classification and reporting rules with the international
standards
Depending on the nature of the concrete measure, the proposed fiscal rules require
legislative changes (including changes in the Constitution), executive orders, internal
parliamentary regulations or informal political consensus between political parties.
2.3. Social policy reform
A complex social reform should aim at achieving the following goals: (i) decreasing
total social expenditures in relation to GDP; (ii) better targeting of various social welfare
programs, which should provide support to the most vulnerable groups in the population; (iii)
diminishing the negative microeconomic and social side-effects of welfare programs, mostly
related to dependency culture, shadow economy and the de-activation of the labor force.
Among various social welfare schemes, the publicly financed PAYG system plays the
most important role. It has one of the highest levels of current expenditures in the world (see
Figure 3) and an enormous size of long-term financial liabilities.

Figure 3: Public pension expenditure as % of GDP in 2004
Note: (2) 2005 for Ukraine, including military pensions, (3) data of 2001
Source: IMF (2007a), Figure 6, p.16
The excessive liabilities of the pension system can be reduced by either decreasing
the replacement rate (i.e. relation between the average pension and the average wage) or
the dependency ratio (i.e. relation between the number of people receiving pension benefits
and those contributing to the system). So far, unavoidable adjustments occurred
spontaneously mainly through the first channel, i.e. either through inflationary depreciation of
only partly and irregularly indexed pension benefits or through slower growth of real pensions
23
when compared to real wages and salaries
18
. However, this approach seems to represent
serious flaws in the area of social fairness.
First, correcting the Pension Fund imbalances through decreasing the replacement
rate means decreasing the relative purchasing power of the average pension, when
compared to the average wage and salary, which if goes too far, could mean increasing the
poverty vulnerability of pensioners. This would also inevitably cause the flattening of the
structure of individual pension benefits (assuming that some minimal, socially justified, size
of pension benefit must exist). This, in turn, would decrease incentives to comply with payroll
tax rules among middle- and higher-income groups of population.
Second and more important, partial and irregular indexation often leads to faster real
depreciation of the earlier granted benefits compared to those newly granted. In practical
terms, this means that older pensioners (representing the “old pension portfolio” and having

limited or no ability to earn additional money) become disadvantaged when compared to
“newcomers”, many of whom can continue work officially or unofficially.
Taking into consideration the above arguments and the rapidly aging population
structure of Ukrainian society (which represents one of the most dramatic national
demographic scenarios in Europe) one should think, first and foremost, about improving the
dependency ratio (or at least stopping its deterioration). This could be done through the
increase of both the official and effective retirement ages (the latter is much lower than the
official due to the existence of various early retirement privileges), which would decrease the
number of pensioners and increase the number of contributors to the Pension Fund, other
things being equal. Another measure of similar character should aim at tightening eligibility
criteria for receiving disability pensions, which could reduce the record-high number of
disability pensioners in Ukraine.
Although not politically easy to implement, the proposed measures (like any kind of
serious social policy adjustment) would mean a better targeting of social benefits (pensions
in this particular case) to the most vulnerable groups in the population (the truly old and
actual invalids) at the expense of the “shadow” zone, of relatively young pensioners, which
can and do continue working, as well as people who abuse the disability pension system.
The measures could also help to stop or limit the otherwise unavoidable tendency to
decrease the replacement rate (see above). Indirectly, they would also decrease incentives
to take up informal employment practices and help to eliminate various kinds of distortions on
the Ukrainian labor market.
Better social targeting should be also the leading principle of reforming other kinds of
social transfers like, for example, various forms of family support. Unfortunately, the political
decisions taken in 2004-2005, such as substantial benefits for each newly born child (see
24
Section 2.3), went in the opposite direction
19
.
3. How can the business climate be improved?
Although is was overcome the following year, the economic slowdown of 2005 (see
Section 2.3) served as the warning signal that the high pace of economic growth observed
between 2000 and 2004 was not guaranteed forever. Apart from windfall factors (high world
prices for metallurgy products), the rapid growth at this period could be attributed, to a
18
Such an approach has been also assumed by Rohozynsky (2007) who analyzes various macroeconomic
scenarios of adjusting social expenditures in the forthcoming years.
19
International experience demonstrates the failure of these kinds of incentives to increase fertility rates.

phenomenon of post-adaptation catching-up recovery, as argued in Section 2.2. However,
the experiences of other transition economies demonstrates that this phenomenon is limited
in time and long-term growth prospects depend on investment dynamics, competitiveness
and more sophisticated qualitative factors.
Ukraine has already experienced an investment boom, these investments have come
mostly from the reinvested profits of existing enterprises as well as from domestic and off-shore
resources of Ukrainian and Russian oligarchs. Other foreign investors, multinational
corporations (MNC) and the stock exchange played a marginal role until very recently. It is
still too early to say whether increased interest in Ukraine among Western investors after the
Orange Revolution (see Section 2.3) indicates a sustainable change in earlier unfavorable
trends.
The same disappointment concerns the other side of the investor spectrum, i.e. the
insufficient dynamic of the SME sector, compared to that observed in Central Europe, Baltic
countries and recently – in the Balkan region. The weakness of FDI and SME can impede
the further restructuring of the Ukrainian economy and increase its international
competitiveness. Most importantly, it reflects a continuous poor business climate in Ukraine,
in spite of some deregulation reforms undertaken in early 2000s and the repeated
deregulation effort in 2005-2006 (see Balcerowicz & Ustenko, 2006).
The poor business and investment climate results from various institutional and
systemic deficiencies such as numerous barriers to market entry (for example, registration
and licensing regimes), various administrative permissions, an excessive number of
administrative inspections, non-transparent tax and custom systems and their poor
administration (especially in respect to VAT), 20 an unstable and intransparent legal system
and its poor implementation, weak and corrupted public administration and judiciary, weak
contract enforcement and insufficient property rights protection, excessive prerogatives of
law enforcement agencies and excessive militarization of the state, the underdevelopment of
financial sector and the underdevelopment and monopolization of infrastructure.
At first glance, Ukraine’s problems with business climate look similar to those
observed in many other transition and less developed countries. However, Ukraine’s
situation in this respect seems to be extremely bad, even when compared to other CIS
countries.
25
20
Numerous flaws in the VAT refunding mechanism have been considered as a particularly serious obstacle to
business activity, especially in relation to large exporters. Some improvement in tax refunding practices was
observed in 2005-2006 but was later reversed.

Figure 4: Heritage Foundation Index of Economic Freedom, 1995-2007
26
33.7
34.5
40.6
39.7
42.9
47.4
46.1
45.4
49.7
51.8
53.7
55.5
53.3
60
55
50
45
40
35
30
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Index of Economic Freedom
Source: http://www.heritage.org/research/features/index/searchresults_past.cfm
Various comparative rankings of the international perception of Ukraine’s business
climate are extremely negative. This is reflected, for example, in the Heritage Foundation
Index of Economic Freedom, which in its 2007 ranking, placed Ukraine in the 125th position
(out of 157 countries ranked), in the category of “mostly unfree” economies, behind most of
the other CIS countries Armenia (32nd position in the ranking), Georgia (35), Kazakhstan
(75), Kyrgyzstan (79), Moldova (81), Azerbaijan (107) and Russia (120). Although Ukraine’s
index improved over the reported period of 1995-2007 (see Figure 4), the pace of
improvement was rather slow and the 2004 Orange Revolution did not accelerate this
process to the extent observed in Georgia after its “Rose Revolution” in 2003. The last rating
(of 2007) was worse than the previous one, which signals a stagnation in economic and
institutional reforms.
Looking at the components of the HF IEF (Figure 5), Ukraine has a decent score in
the categories of “Fiscal Freedom” (89.1) and “Trade Freedom” (72.2), both above the world
average. In all other categories, however, Ukraine performs below the world averages.
“Freedom from Corruption” (26.0), “Property Rights” (30.0) and “Investment Freedom” (30.0)
are the components where Ukraine’s track record looks especially poor.

Figure 5: Heritage Foundation Index of Economic Freedom, 2007, components
Source: http://www.heritage.org/research/features/index/countryFiles/pdfs/Ukraine.pdf
The World Bank Doing Business is the second important ranking, which generally
confirms the pessimistic outlook provided by the HF IEF. According to WB Doing Business
2007 publication (Doing Business, 2006), which presents survey data for 2006, Ukraine is
ranked on the 128th position among 175 countries examined, behind Armenia (34), Georgia
(37), Kazakhstan (63), Kyrgyzstan (90), Russia (96), Azerbaijan (99), and Moldova (103). It
belongs to the group of countries where the business environment is characterized as
“difficult”. Only in one category (“Enforcing Contracts”) Ukraine is ranked quite favorably
(26th position). The worse performance is scored in respect to “Paying Taxes” (174th
position), “Protecting Investors” (142), “Closing a Business” (139) and “Registering Property”
(133). The 2006 ranking demonstrates a slight improvement compared to the previous year,
mostly in the categories of “Starting a Business” and “Dealing with Licenses”. However, the
unavailability of 2007 survey results at the moment of writing this paper does not allow for
verifying the HF observation that the business climate deteriorated in 2007.
Looking at the potential strategies aimed at improving business and investment
climate, one must remember that the room for maneuver for quick fixes is limited due to the
fundamental flaws of many basic state institutions such as public administration or judiciary
(see Section 5). For example, the judicial control of administrative decisions, which
constitutes the basic protection mechanism of business freedom in developed countries, is
not available to Ukrainian entrepreneurs because of the very poor performance of the
Ukrainian court system and - more generally – a lack of respect for the rule of law. This
bottleneck only can be partly substituted by the monitoring provided by civil society
organizations and by the special administrative agency, which plays the role of “entrepreneur
ombudsman”, i.e. the State Committee of Ukraine for Regulatory Policy and
Entrepreneurship.
27

The above circumstances mean that more sophisticated regulatory solutions copied
from the developed countries might not necessarily work well in Ukraine, at least in the near
future. Instead, they call for simple and radical deregulation measures such as abandoning
some non-priority areas of regulations and closing down or substantially downsizing
institutions in charge of these regulations (to avoid bureaucratic attempts of reversing
deregulation). This approach was successfully adopted in Georgia after the Rose Revolution
in 2003 (see Lessons, 2006).
The regular verification of all existing regulations where ministries and agencies must
justify prolongation of each single executive order (the so-called “Guillotine” principle
adopted, among others, in Moldova in early 2000s) in another good measure protecting
economic freedom. Finally, widespread application of online e-procedures (in business
registration and licensing, applying for administrative permissions, tax and custom reporting
and settlements, public procurement, etc.) could make compliance with various
administrative procedures more transparent, less expensive and less time-consuming for
both public administration workers and business people.
4. Reforming a post-Soviet state
As mentioned previously the poor business climate in Ukraine has its roots in the
unreformed post-Soviet state which continues to perform several functions typical for a
command economy and non-democratic political regime. As in the Soviet or even pre-Soviet
era, the Ukrainian state apparatus still tries to interfere in the details of business activity and
the day-to-day life of its citizens while it is unable to provide them with basic public goods
such as law and order, security, judiciary, equal and fair treatment of all citizens and firms,
basic technical and social infrastructure, etc. This kind of bureaucratic patrimonialism creates
a fertile ground for corruption (see Dubrovskiy, 2006), which is widely considered the number
one social and economic disease in Ukraine.
The Transparency International Corruption Perception Index of 2006 gave Ukraine
99-104th position among 163 analyzed countries, together with the Dominican Republic,
Georgia, Mali, Mongolia and Mozambique. It was behind Moldova (79-83th position) and
Armenia (93-98), and ahead of other CIS countries. The score of 2.8 in 200621 represents a
modest improvement compared to 2005 (2.6) and 2004 (2.2).
28
21
In the scale of 0-10 where 0 means highly corrupt and 10 – highly clean country – see
http://www.transparency.org/policy_research/surveys_indices/cpi/2006

In addition, due to slow privatization, many enterprises remain state-owned and are
thus easy targets of rent seeking and rent extraction, and create development bottlenecks in
some important infrastructure sectors, such as telecommunication, energy production and
distribution and transportation.
The weakness of state institutions is caused, among others, by insufficient
democratization, weak civil society, an unstable and immature system of political parties
(penetrated by powerful business elites representing their interests), and an inefficient and
corrupted judiciary. In spite of major political improvement after the Orange Revolution,
Ukraine still lags, in many respects, behind not only mature Western democracies but also
the countries of Central and Eastern Europe, which recently joined the EU.
According to the Freedom House “Freedom in the World” 2007 annual report,22
Ukraine belongs to the group of “free” countries23 but its scores (3 for political rights and 2 for
civil rights) lag behind the EU standard of 1 for both categories, which all countries meet
apart from Bulgaria and Romania. However, the regional “Nations in Transit” ranking run by
the same institution and covering a wider set of indicators reveals some important
vulnerabilities of the young Ukrainian democracy. As shown in Table 3, Ukraine’s
performance in four specific areas – “Judicial Framework and Independence”, “National
Democratic Governance”, “Local Democratic Governance” and “Corruption” – continues to
be disappointing and shows little or no improvement compared to the early 2000s.
Table 3: Ukraine: Freedom House Nations in Transit Ratings, 1999-2007
29
22
http://www.freedomhouse.org/uploads/fiw/FIWAllScores.xls
23
As of 2006. Earlier it belonged to the category of “partly free countries”.

Source: http://www.freedomhouse.hu//images/fdh_galleries/NIT2007/nt-ukraine-proof-ii.pdf
These vulnerabilities determine the suggested agenda of future political and
institutional reforms. They should start from the attempt to revise and clarify the constitutional
division of power to avoid the repetition of political stalemates observed in 2006-2007.
Constitutional amendments adopted in the wake of the Orange Revolution (on
December 8, 2004) changed Ukraine’s political regime from the presidential-parliamentarian
to the parliamentary-presidential one. The general direction of these changes can be
considered correct. The transition experience of post-Soviet countries has demonstrated
numerous flaws of strong presidencies such as the danger of authoritarian drift, unavoidable
conflict between the executive and legislative branches of government, dysfunctionality of a
two-head executive power (unclear division of responsibility between president and prime
minister, ambiguous role of presidential administrations), impediments to building stable
political parties, the oligarchization of political life, etc. However, the concrete wording of
constitutional amendments hastily adopted in the revolutionary atmosphere of December
2004 proved vague and incomplete. As a result, it led to a severe political crisis just after the
parliamentary election of 2006 when the new constitutional arrangements finally became
operational.
This unfortunate experience should serve as the warning signal and background for
the reexamination of constitutional checks and balances between legislative and executive
branches and within the latter, i.e. between president and prime minister. First and foremost,
a constitutional review should relate, in first instance, to a process of forming a parliamentary
majority, appointment of the prime minister and government, dissolution of parliament,
political control of armed forces and law enforcement agencies and the role of presidential
veto in the legislative process.
Apart from further constitutional changes, the modernization of the Ukrainian state
requires several other institutional reforms such as:
i. A complex administrative reform in order to improve the efficiency of government
agencies and to focus them on providing basic public goods and services that cannot
be supplied by the market mechanism. To achieve this, the government and public
administration structure must be simplified, redundant and unnecessary functions
eliminated, the number of personnel reduced, and the resulting budget savings used to
increase the salaries of the remaining civil servants.
ii. The administrative reform must be supplemented by the consequent building of the
professional, stable and apolitical civil service corps on the central, regional and local
30

levels. This includes, among others, drawing a clear distinction between political and
non-political positions in the government apparatus. The selection of candidates for
public service must be based exclusively on professional criteria and on an open,
competitive mechanism. It is also necessary to modernize the professional training of
civil servants, and to define clear principles for their professional careers and
remuneration.
iii. Failure to build a modern system of local and regional self-government has substantially
weakened Ukrainian democracy and the Ukrainian state. A reasonable level of
decentralization could increase the efficiency of governing such a large, populous and
ethnically and culturally diverse country as Ukraine, bring democracy closer to citizens,
and at least partly soften inter-regional conflicts., First and foremost, this would require
overcoming the post-Soviet tradition of centralism and the unjustified fears of some
politicians that excessive decentralization may lead to the disintegration of the Ukrainian
state. Successful decentralization requires not only a clear delineation of prerogatives
and public tasks between central, regional and local government but also a parallel
transferring of financial resources needed to carry out these prerogatives and tasks.
Regional and local legislative bodies should approve their own budgets, and the
expenses should be directed toward executing their own tasks, as well as delegated
ones. Meanwhile revenues should be ensured through regional and local taxes and
grants.
iv. The excessive militarization of many state functions, one of the legacies of the Soviet
period, should be overcome by bringing the armed forces and various law enforcement
agencies under effective democratic control, following dominant European standards.
Their mandate and tasks should be clearly defined and strictly limited to providing public
goods such as external and internal security and efficient law enforcement.
v. Anti-corruption policy must include a variety of measures, in particular, improved anti-corruption
legislation and deregulation of business activity. Individuals, enterprises,
NGOs and media should have free access to information. Increased transparency of
national and local budgets, public tenders, administrative procedures and decisions
could be achieved though the use of e-government instruments
However, special attention should be given to a comprehensive legal and judicial
reform. A radical improvement of the judiciary is absolutely critical to ensure the effective
enforcement of constitutional rights and freedoms, improvement in rule of law and business
climate, particularly protection of better property rights and contract enforcement, curbing
arbitrary and predatory behavior of public administration and law enforcement agencies. This
31

reform must encompass reforms of legal education, material and procedural legislation,
reform of law enforcement agencies such as the prosecutor’s office, various branches of
police forces, the Security Service of Ukraine (SBU), etc.), better execution of court
decisions, the penal system, and legal services (including the Bar, notary services, etc.).
Because such complex institutional changes require a lot of time to be implemented and
bring substantial improvement, implementation should begin as soon as possible, drawing on
foreign expertise and technical assistance.
An independent judicial system must include regular courts, magistrate courts, and
specialized judicial and quasi-judicial bodies, with clearly defined legal mandates
32
24
. Both
prosecutors and judges should enjoy independent status (lifetime nominations after
scrupulous selection and examination of candidates), be accountable only to the law and
code of professional ethics, and much better trained and remunerated (to resist corruption
temptation).
5. The challenge of globalization and economic integration
Another potential obstacle to the future economic growth of Ukraine is connected with
its insufficient trade and economic relations with developed countries, particularly with the
enlarged European Union. As demonstrated in Table 4, the geographic structure of
Ukraine’s trade changed very little in the first half of the 2000s. In fact, the share of total
exports to EU and EU candidates (Turkey playing the most prominent role among the latter)
decreased over the analyzed period. Russia and other CIS and developing countries remain
the main destinations of Ukrainian export.
Export geography is closely linked with its commodity structure (see Table 5); low-processed
ferrous and non-ferrous metals, chemicals, food and other raw-materials continue
to represent almost two-thirds of the total. If we add the technically outdated products of the
machine building industry and fuel and energy products (part of which are re-exported after
being produced in other CIS countries), we get a picture of the weak international
competitiveness of the Ukrainian economy and its continues dependence on intra-CIS
markets. Most of the export products have a limited chance to be sold in developed
countries. They can still be exported to CIS and some developing countries but this window
of opportunity will not last indefinitely, especially when taking into consideration the
24
In the last couple of years, one could observe such legal paradoxes such as a ruling on the legality of a
Presidential decree by an ordinary district court instead of the Constitutional Court.

increasing openness of developing countries and increasing trade competition on world
markets.
More changes have been observed on the import side in the analyzed period, with the
share of fuel and energy products from CIS slowly diminishing, and the share of machinery
from the EU slowly increasing (see Tables 4 and 5). Nevertheless, the import structure (in
terms of geography and commodity composition) also looks different from most of the EU
new member states and EU candidates in South Eastern Europe (SEE). SEE countries trade
mostly with the EU and manufacturing products (including intra-industry trade) prevail in their
trade flows. The continuous high energy-intensiveness (one of the highest in the world),
especially in export-oriented industries such as metallurgy and chemical products, makes the
Ukrainian economy strongly dependent on oil and gas import from Russia, and vulnerable to
changes in oil and gas prices.
Table 4: Ukraine: Geographic Structure of Trade, 2001-2005, % of total
Exports Imports
33
Region/Country
2001 2002 2005 2001 2002 2005
CIS 28.7 24.4 31.3 56.0 52.8 47.1
Russia 22.6 17.8 21.9 36.9 37.2 35.5
Belarus 1.5 1.5 2.6 2.6 1.5 2.6
Other 4.6 5.2 6.9 16.6 14.1 9.0
EU + EU candidates 40.1 42.4 35.8 31.0 33.6 35.4
Germany 4.4 4.2 3.8 8.7 9.8 9.4
Turkey 6.2 6.9 5.9 0.9 1.2 1.7
Other 29.5 31.3 26.1 21.4 22.7 24.4
Rest of the World 31.2 33.2 32.9 13.0 13.6 17.5
USA 3.5 2.9 2.8 2.9 2.8 2.0
China 3.3 3.9 2.1 1.2 1.5 5.0
Other 24.4 26.4 28.0 8.9 9.3 10.5
Source: IMF (2007c), Table 30, p.34, Table 32, p.36
Table 5: Ukraine: Commodity Structure of Trade, 2001-2005, % of total
Exports Imports
Commodity group
2001 2005 2001 2005
Fuel and energy products 9.9 12.8 41.8 31.4
Machinery 14.4 13.5 21.0 28.0
Wood and wood products 3.2 2.9 3.9 3.3
Industrial products 5.2 3.6 6.0 6.0
Chemicals 11.5 11.3 12.4 14.6
Food items and raw materials 11.2 12.6 7.1 7.4
Ferrous and nonferrous metals 41.3 41.0 5.2 6.8
Other 3.3 2.3 2.6 2.6
Source: IMF (2007c), Table 31, p.35, Table 33, p.37

Summing up, in spite of the high level of openness of the Ukrainian economy (the
ratio of exports plus imports to GDP equaled ca. 120% in 2003
34
25
) it remains partly isolated
from Western markets and its international competitiveness is rather low. Contrary to EU
NMS and EU candidates, Ukraine experienced only limited trade restructuring in the
transition period. This was caused by both the slow and uneven pace of domestic reforms
(see above) and by the protectionist attitude of the West, particularly of the EU to the whole
CIS region in the 1990s and early 2000s. Unfinished WTO membership negotiations do not
help to decrease the international perception of risk in trading with Ukraine and investing in
this country. As a result, Ukraine’s trade relations are less stable, badly institutionalized and
lacking in legal instruments which could defend national interests, for example, against the
anti-dumping measures regularly adopted by countries importing Ukrainian metallurgy and
chemical products. On the other hand, weak trade relations with developed countries,
including the EU, create an additional obstacle to the deep restructuring and modernization
of the Ukrainian economy and increasing its long-term growth potential.
Coming back to EU policy, one must notice a fundamental difference between the EU
trade policy on offer to Central European, Baltic and Balkan countries on the one hand and
CIS countries on the other. In the 1990s and early 2000s, the CIS countries, including
Ukraine, were left completely outside of the EU integration process and were not even given
the opportunity to liberalize their trade with the EU. The Partnership and Cooperation
Agreement (PCA) which Ukraine signed in 1994 and which entered into force in 1998 was
the only legal platform of bilateral relations. It included standard trade and economic
provisions like the most-favored-nation (MFN) clause but not limited trade liberalization.
Furthermore, the EU did not offer CIS countries the opportunity to negotiate and sign free
trade agreements (FTA) prior to, or in parallel with, their WTO accession. The official EU
policy was: WTO accession first and only afterwards can free trade feasibility studies and
negotiations begin. This was a major difference compared to the attitude adopted towards
EU candidates – some of them were allowed to sign a comprehensive FTA agreement with
the EU parallell to, or even before formally completing the WTO accession process.
Excluded from the global and European trade liberalization processes, CIS countries
made several, largely unsuccessful attempts to build their own regional trade block. The CIS
itself, had, among other goals (such as being the mechanism for the peaceful political
dissolution of the former Soviet Union) the goal to forming a kind of post-Soviet common
market. However, the subsequent multilateral and bilateral free trade agreements between
25
CASE ENEPO WP1 database based on the Penn World Table 6.1 (PWT 6.1),
http://pwt.econ.upenn.edu/php_site/pwt62/pwt62_form.php

CIS countries were never fully implemented. The same concerned the more ambitious
integration projects like the Single Economic Space between Belarus, Kazakhstan, Russia
and Ukraine (which has the Russian acronym EEP). Their failure was caused by a number of
political, economic and institutional reasons: lack of political trust between partners,
asymmetry of the countries’ economic and political potentials, a divergence of national
economic interests, the varied pace of economic reforms, the lack of effective enforcement
and arbitrage mechanisms and others. Although intra-CIS regional trade liberalization does
work to limited extent, it helps very little in restructuring and modernizing CIS economies,
because all the partners have development problems. In this respect CIS trade liberalization
mechanisms, although important for the Ukrainian economy, cannot be considered a
substitute for global or European trade and economic integration.
The EU attitude towards the European part of the CIS, particularly Ukraine, has
started to change only very recently, after the EU Eastern Enlargement in 2004 and 2007.
Now Ukraine shares land borders with four EU members: Poland, Slovakia, Hungary and
Romania. For geographic and geopolitical reasons, the new EU members are, on average,
more interested in developing close economic and political relations with the CIS than
countries of Western or Southern Europe. These geopolitical changes and the positive
international expectations created by the Orange Revolution opened a new window of
opportunity for Ukraine to build closer trade, investment and institutional relations with the
EU.
The European Neighborhood Policy, which was officially launched in 2004, became
the new EU institutional policy framework towards its direct neighbors. According to the
26
, the EU offers its neighbors “…a privileged relationship, building
35
official public statement
upon a mutual commitment to common values (democracy and human rights, rule of law,
good governance, market economy principles and sustainable development). The ENP goes
beyond existing relationships to offer a deeper political relationship and economic integration.
The level of ambition of the relationship will depend on the extent to which these values are
effectively shared.” Originally this general declaration was followed by a clear statement that
the ENP is not about the next EU enlargement and does not offer an EU accession
perspective. Recently it was replaced by a more flexible approach: “The ENP remains
distinct from the process of enlargement although it does not prejudge, for European
neighbors, how their relationship with the EU may develop in future, in accordance with
Treaty provisions.” The door has been hypothetically opened for European CIS countries
such as Ukraine. However, this seems to portray a very distant and unclear perspective,
26
http://ec.europa.eu/world/enp/policy_en.htm

especially if one takes into consideration the “enlargement fatigue” phenomenon, recently
27
.
observed in some countries of Western Europe
Under the ENP initiative, the EU-Ukraine Action Plan was signed in February 2005
(see Section 2.3). On March 5, 2007 the EU and Ukraine started to negotiate a
comprehensive new Enhanced Agreement, which is going to replace the old PCA. The EU
negotiation mandate includes the proposal of a deep FTA, i.e. an agreement which would go
beyond simply reducing or eliminating import tariffs. It should also touch on most of the
existing non-tariff barriers, remove investment obstacles and initiate far-reaching institutional
harmonization in the selected sectors. This type of agreement, if concluded and
implemented, would not only bring substantial welfare gains to Ukraine (4-7% according to
Emerson et al., 2006 modelling exercise) but also facilitate a far-reaching restructurization
and modernization of the Ukrainian economy and closer harmonization of Ukraine’ economic
and legal system with the EU acquis. This, in turn, would make the future EU accession
perspective more realistic and feasible.
36
Conclusions
Sixteen years after obtaining independence and three years after the Orange
Revolution, Ukraine has reached a crossroads. It has broken with the Soviet and totalitarian
past but its democracy is still relatively young and fragile, and therefore vulnerable to various
political shocks. Basic civil and economic freedoms are not well protected due to numerous
legal and institutional imperfections, most notably a poorly performing judiciary. Ukraine has
succeeded in building the basic institutional foundations of a market economy. However, its
capitalism is heavily distorted and its economic transition is far from complete. The economic
landscape is dominated by large financial-industrial groups, the so called ‘oligarchs,’ whose
short term interests override the interests of SME owners, foreign investors and consumers
thanks to non-transparent political mechanisms. After ten years of transformation output
decline, the economy is growing at a relatively high pace, but the long-term sustainability of
this growth will depend on an improvement in investment climate. In geopolitical terms,
Ukraine did not make its final choice yet – whether it is going to participate seriously in the
Euro-Atlantic integration or remain in the ‘grey zone’ of the European periphery. Even making
a firm political commitment in favor of the first choice does not guarantee that it will be given
the chance to materialize quickly. For many reasons, Ukraine’s road to EU and NATO
membership will be more difficult than that of countries of Central and Eastern Europe. The
27
This anti-enlargement sentiment works particularly strongly against the EU membership aspirations of Turkey,
for historical and cultural reasons. However, one can expect a similar reaction in respect to the hypothetical EU
membership aspirations of Ukraine.

external incentives for Ukraine are much weaker than those enjoyed by those countries
which joined the EU in 2004 and 2007.
Similarly to other CIS countries, Ukraine urgently needs a new round of reforms which
would primarily address the institutional and structural weaknesses. Compared to the earlier
stage of economic transition, Ukrainian policymakers must go well beyond the purely
economic agenda and also address issues of legal, administrative and political reforms.
These are absolutely critical to create a healthy business environment and integrate Ukraine
with the world and European economy. Failure to design, launch and implement such
reforms can undermine prospects of economic growth in both the medium and long term
perspective as well as the chances to speed up the modernization processes.
The politics and political economy dimensions of taking the strategic decisions
outlined above will not be easy. The country is deeply divided in political, cultural, regional
and ethnic terms. There is little chance that a clear winner will emerge from the September
2007 parliamentary elections. Thus, forming a stable government with coherent and
consistent program will not be an easy task. The political struggle will probably continue at
least until the 2009 presidential election. In such an environment, crucial reforms and
strategic decisions – whether subsequent constitutional reform, major institutional changes or
Ukraine’s relations with the EU and NATO – will require a wider cross-party political
consensus.
37
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